Working Paper No. 837 Financing the Capital Development of the Economy: A Keynes-Schumpeter-Minsky Synthesis by Mariana Mazzucato* University of Sussex L. Randall Wray† Levy Economics Institute of Bard College May 2015 * [email protected] † [email protected] This paper was prepared for the project “Financing Innovation: An Application of a Keynes-Schumpeter- Minsky Synthesis,” funded in part by the Institute for New Economic Thinking, INET grant no. IN012-00036, administered through the Levy Economics Institute of Bard College; Mariana Mazzucato (Science Policy Research Unit, University of Sussex) and L. Randall Wray (Levy Institute) are the project’s co-principal investigators. The authors thank INET, SPRU, and the Levy Institute for support of this research. The Levy Economics Institute Working Paper Collection presents research in progress by Levy Institute scholars and conference participants. The purpose of the series is to disseminate ideas to and elicit comments from academics and professionals. Levy Economics Institute of Bard College, founded in 1986, is a nonprofit, nonpartisan, independently funded research organization devoted to public service. Through scholarship and economic research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. Levy Economics Institute P.O. Box 5000 Annandale-on-Hudson, NY 12504-5000 http://www.levyinstitute.org Copyright © Levy Economics Institute 2015 All rights reserved ISSN 1547-366X Abstract This paper discusses the role that finance plays in promoting the capital development of the economy, with particular emphasis on the current situation of the United States and the United Kingdom. We define both “finance” and “capital development” very broadly. We begin with the observation that the financial system evolved over the postwar period, from one in which closely regulated and chartered commercial banks were dominant to one in which financial markets dominate the system. Over this period, the financial system grew rapidly relative to the nonfinancial sector, rising from about 10 percent of value added and a 10 percent share of corporate profits to 20 percent of value added and 40 percent of corporate profits in the United States. To a large degree, this was because finance, instead of financing the capital development of the economy, was financing itself. At the same time, the capital development of the economy suffered perceptibly. If we apply a broad definition—to include technological advances, rising labor productivity, public and private infrastructure, innovations, and the advance of human knowledge—the rate of growth of capacity has slowed. The past quarter century witnessed the greatest explosion of financial innovation the world had ever seen. Financial fragility grew until the economy collapsed into the global financial crisis. At the same time, we saw that much (or even most) of the financial innovation was directed outside the sphere of production—to complex financial instruments related to securitized mortgages, to commodities futures, and to a range of other financial derivatives. Unlike J. A. Schumpeter, Hyman Minsky did not see the banker merely as the ephor of capitalism, but as its key source of instability. Furthermore, due to “financialisation of the real economy,” the picture is not simply one of runaway finance and an investment-starved real economy, but one where the real economy itself has retreated from funding investment opportunities and is instead either hoarding cash or using corporate profits for speculative investments such as share buybacks. As we will argue, financialization is rooted in predation; in Matt Taibbi’s famous phrase, Wall Street behaves like a giant, blood-sucking “vampire squid.” In this paper we will investigate financial reforms as well as other government policy that is necessary to promote the capital development of the economy, paying particular attention to increasing funding of the innovation process. For that reason, we will look not only to Minsky’s ideas on the financial system, but also to Schumpeter’s views on financing innovation. Keywords: Banker as Ephor of Capitalism; Capital Development; Finance; Global Financial Crisis; Innovation; Minsky; Schumpeter JEL Classifications: B5, B51, B52, G, G1, G2, H6, L5, N1, O1, O2, O3, O4, P1 1 1. INTRODUCTION This paper discusses the role that finance plays in promoting the capital development of the economy, with a particular emphasis on the current situations of the United States and the United Kingdom.1 “Capital development” is a term defined by Hyman Minsky to refer to a broad measure of investment that goes beyond privately owned capital equipment and to include technology, human capital, and public infrastructure. This paper will provide a brief synthesis of the main contributions of three of the twentieth century’s greatest thinkers: J. M. Keynes, Josef A. Schumpeter, and Hyman P. Minsky. We define both “finance” and “capital development” very broadly. We begin with the observation that the financial system evolved over the post-war period from one in which closely regulated and chartered commercial banks were dominant, to one in which financial markets dominated the system. Over this period, the financial system grew rapidly relative to the nonfinancial sector, rising from about 10% of value added and a 10% share of corporate profits to 20% of value added and 40% of corporate profits in the US (see below). This was, to a large degree, because instead of finance financing the capital development of the economy, it was financing itself. The speed at which the financial sector grew was boosted by these high profits, growing capital more quickly than non-financial firms. Indeed, the origins of the financial crisis and the massive and disproportionate growth of the financial sector began in the early 2000s when banks increasingly began to lend to other financial institutions via wholesale markets, lending mainly to hedge funds, private equity, and subprime mortgages because the returns were higher than those garnered from lending to industry or government. They further magnified the return on equity by raising leverage ratios, and multiplied their capital gains through speculative purchases using funds borrowed in very short-term markets (such as commercial paper), endangering their liquidity and solvency. The risks escalated, but were severely underpriced. The result was that banks’ assets ballooned, but success was based on outcomes that were unlikely to be realized. When asset prices fell, the margin of error was so small that even a small loss ratio would have led to a bust. 1 London and New York are the most important financial centers; the euro area has also experienced similar problems, made more complicated by the unusual monetary arrangements (each member state is responsible for its own financial institutions but with limited fiscal and monetary policy independence). 2 Figure 1 US Financial Sector Share of Corporate Profits and Value Added Financial Industry Share of Corporate 45.00 Profits and Value Added (1955-2010) 40.00 Share of Profits 35.00 30.00 Value Added (% of GDP) 25.00 20.00 15.00 10.00 5.00 0.00 2009 2001 1971 1995 1955 1957 1959 1961 1963 1965 1967 1969 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1997 1999 2003 2005 2007 Source: Bureau of Economic Analysis. But before that happened, bank assets and profits expanded relative to the rest of economy, which also led to an increase of their value added contribution in the national accounts. Unlike other industries, banks’ value added contribution depends on the margin between the interest rates charged on their loans and those paid on their deposits (for the UK, see Grovell and Wisniewski 2014; for the US, see Hood 2013). Figure 2 shows this trend for the UK. Figure 2 Gross Value Added (Indices 1975=100)—UK 1945–2013 Source: Alessandri and Haldane 2009 (2009–2013 extended by authors with data from the Bank of England). 3 Further, as has been noted by many commentators, the nonfinancial sector became highly financialized by many measures, including debt ratios, as well as the proportion of income generated by financial activities (even industrial powerhouses like GM and GE created financial arms that generated much of their profits, and most large firms began to treat cash balances as a financial asset to generate revenue). At the same time, the capital development of the economy suffered perceptibly. If we apply a broad definition to include technological advance, rising labor productivity, public and private infrastructure, innovations, and advance of human knowledge, the rate of growth of capacity has slowed. Admittedly, this is a difficult claim to demonstrate. In some areas, advances have come at a very rapid, almost revolutionary, speed. However, the US and UK are falling behind in many basic areas, including universal education, health improvements, public and private infrastructure, and poverty alleviation. The American Society of Civil Engineers’ (ASCE) infrastructure report card awarded an overall D+ in 2013 to the US, estimating that $3.6 trillion of infrastructure investments are needed by 2020. Almost none of the infrastructure needed to keep the US competitive in the global economy received a grade above a D. Table 1 ASCE’s 2013 Report Card for America’s Infrastructure Water & Transportation Environment Dams D Aviation D A = Exceptional Drinking Water D Bridges C+ B = Good Inland Hazardous Waste D D- C = Mediocre Waterways Levees D- Ports C D = Poor Solid Waste B- Rail C+ F = Failing Wastewater D Roads D Transit D Public Facilities Public Parks & C- Energy D Recreation Schools D Energy D Source: American Society of Civil Engineers. 4 Further, even as the financial sector experienced serial booms (and busts), the infrastructure situation has actually worsened across most of these categories, as the estimate of the spending required nearly tripled over the years, rising from $1.3 trillion in 1998.